Our Recent Posts


No tags yet.

Cryptographic Currencies and the Disintermediation of the Central Bank Model

Published on July 26, 2018

The New York Federal Reserve (NY Fed) is one of 12 US Federal Reserve Banks that make up the Federal Reserve System (US Fed). The website maintained by the NY Fed goes into a surprising level of detail surrounding the security protocols in place protecting the 508,000 gold bars custodied by the NY Fed on behalf of foreign governments. The kind of security surrounding the gold bars is symbolic of the "old economy" and are security protocols that can be considered adequate when protecting something as tangible as gold bars. According to the New York Times (NK Hacker Army) as of October 2017, North Korea had a force of 6,000 hackers actively refining their ability to penetrate systems outside of North Korea. In 2016, the North Korean Government through their "hacker army" attempted to steal $1 billion dollars held by the NY Fed on behalf of the country of Bangladesh. This hack involved the manipulation of the NY Fed through the compromised networks maintained by the Bangladesh Central Bank that were breached by the North Koreans. The hack was responsible for the payout by the NY Fed at the direction of the North Korean government of $101 million. The shortfall ($899 million) was due to the recognition of slight anomalies in the formatting and language of the wire transfer instructions by NY Fed human analysts. The North Korean hackers also exploited an extended weekend holiday taking place in Bangladesh at the time of the hack with employees being out of the office for a longer than average period. The $101 million that was paid out to the bad actors by the NY Fed took place in five disbursements. Finger pointing continues to this day between the NY Fed and the Society for Worldwide Interbank Financial Telecommunication (SWIFT), a platform used by 11,000 financial institutions worldwide to facilitate wire transfers. According to an investigative report on the incident published by Reuters (NK Bangladesh Hack Report), the hackers took advantage of not only the extended Bangladeshi holiday, but also the NY Fed's inability to conduct real-time transaction analysis. Like most financial institutions based in North America, Europe, and Asia, the majority of transaction monitoring takes place once suspicious transactions have already occurred. Also, because it was the weekend in Bangladesh and additional malware had been installed on the Bangladesh central bank's systems, questions posed by the NY Fed to the authorities in Bangladesh over concerns related to the questionable wire transfer instructions could not be answered. When you think about it, this is a crime that could have been carried out when large global institutions were communicating via telegraph. I bring this up not to necessarily criticize the NY Fed for antiquated systems when solving financial crimes, but to highlight how the US Fed and other central banks should embrace the ability of cryptographic currencies (specifically bitcoin) to enhance security and dramatically improve other central bank functions that can only be accomplished when sharing a common global currency on a shared universal platform.

Dissatisfaction with the fiat currency system and the idea of robbing the poor to benefit the rich is at the root of Satoshi Nakamoto's creation of bitcoin and the blockchain. The system of central banks is in the crosshairs of Nakamoto's 2008 white paper by emphasizing the elimination of a centralized authority when issuing units of currency. Bitcoin and blockchain ushered in the idea of a fixed monetary supply, taking the human element out of monetary creation, in other words, stabilizing monetary unit creation by not reacting to positive or negative economic developments benefitting the sovereign central bank reacting to those events. Regarding the possibility of a cryptographic currency created by the US Fed, European Central Bank (ECB) or Peoples Bank of China (PBoC), the danger of centralization is extremely high. As demonstrated in the creation and deployment of the Venezuelan Petro and the possibility of the CryptoRuble under control of the Russian Central Bank. Centralized control takes away the most powerful dimension of currencies built upon blockchain technology, DECENTRALIZATION. It is possible to add a scaled-down decentralized feature when creating a sovereign cryptographic currency in the mold of bitcoin, but the temptation to maintain centralized control would not be checked by a larger number of diverse, unincorporated, free international "miners" active on the scale of the bitcoin blockchain.

It is interesting to see how the various central banks around the world are coping with what many see as a threat to their dominance in all things related to monetary policy. I decided to use this post to "take the temperature" of where a few of the major central banks and the central bank "industry association" stand in relation to their embrace of cryptographic currencies.

View from the US Fed

Earlier this year, the Federal Reserve Bank of St. Louis released a report (St. Louis Fed) acknowledging the unique power of cryptographic currencies and the positive impact those currencies can have on the economy. The US Fed also warned not to expect the release of their own decentralized, permissionless and pseudonymous cryptographic currency. This was not the first reference to cryptographic currencies by the US Fed. Comments made by previous US Federal Reserve Chairpersons such as Ben Bernanke (virtual currencies are "innovative payment systems"), and Janet Yellen (cryptographic currency a "highly speculative asset" and remains a "very small part of the overall payment system") received significant media attention. Current US Fed Chair Jerome Powell announced that cryptographic currencies aren't big enough yet to make a significant impact on the US economy, but that the US Fed is monitoring this area "very carefully."

View from the ECB

The president of the ECB, Mario Draghi has indicated that it is not the job of the ECB to regulate cryptographic currencies. Draghi echoes a similar refrain that other leaders within financial services tend to repeat that "nobody backs bitcoin." Once again, as I've pointed out in past posts, with the tenth anniversary of bitcoin this coming January, it is shocking that someone at the level of Mario Draghi still doesn't understand the mechanics and legitimate benefits of a decentralized currency (McCalmont Collateral-Damage). In early 2018, the ECB announced that cryptographic currency was not really a priority at this time as they were focusing on interest rate policy and recovery of the European economy (ECB Priorities). The ECB also pointed to a lack of interest on the part of European banks, which the ECB saw as a positive due to the price volatility and minimal usage on the part of European citizens (European Bank Risk).

View from The PBoC

Last March, the PBoC announced that one of their top three priorities for all of 2018 will be ensuring the integrity of the Chinese yuan at the same time highlighting the ongoing progress into digital currency research and development (PBoC Yuan Risk). In March, the PBoC banned ICOs and forced fiat-to-crypto exchanges to close while the Chinese Ministry of Public Security announced that it had increased their surveillance of foreign crypto-exchanges as a way to further "protect" potential Chinese investors. China is exploiting the open-source nature of blockchain currencies for the internal monitoring of its citizens outside the physical borders of China. According to reports, the PBoC assembled a research team in 2014 to explore the possibility of issuing a national digital currency. This action stems from China's adoption of digital payment platforms such as WeChat and Alipay. Many economists believe that China will be the first country to become entirely cashless (Cashless China). That being said, the PBoC has stated publicly that any digital currency defined as legal tender must only be issued by the PBoC itself. (PBoC Digital Trial). China is in support of participating in global governance of digital currencies (Global Cryptocurrency Regulations). China seems to be one of the most aggressive countries moving into a dominant position within the digital currency universe, but also appears to be walking a fine line in accepting a citizenry engaged in currency transactions outside the control of the PBoC.

View from The Bank For International Settlements (BIS)

In February 2018 the head of the BIS Agustin Carstens described bitcoin as a "bubble, a Ponzi scheme and an environmental disaster." Like Mario Draghi before him, Carstens provides another example of damaging comments made by "established" financial professionals when commenting on this technology and completely overlooking the benefits for the developing world. In a way, I understand why some central bankers are openly hostile and conveniently ignorant of the technology because a significant portion of their reason for being will cease to exist. The smooth, stable release of a set number of bitcoins added to circulation (approximately) every ten minutes will eliminate the need for central banks to react to fluctuating economic conditions to benefit their sovereign operations inflicting economic harm on other countries. The BIS, as an advocate for central banks around the world, are extremely interested in preserving the power of the central banks. With economic conditions so horrific within emerging economies, I would argue that since the establishment of the BIS in 1930, their creativity in pursuing global financial stability has fallen far short of expectations. Because of the consolidation of power established within these centralized organizations, countries, particularly those within the Global South have suffered tremendously (McCalmont Anti-Corruption).

If central banking institutions were to adopt the use of bitcoin as a global proxy when establishing monetary policy, the smooth, stable release of bitcoin units (in 2018, 12.5 bitcoin created and placed into circulation approximately every ten minutes) at the direction of preprogrammed computer code takes away the human component that injects bias into monetary policy, potentially disrupting a naturally functioning economy. The fact that the US Fed carried out quantitative easing post-2008 financial crisis, many critics believe that manipulation of interest rates did more damage than good. Quantitative easing increases the money supply directed at financial institutions with the goal of promoting increased lending. The US Fed is the classic intermediary by settling payments between financial institutions. In the world of cryptographic currencies, the intermediary role of the US Fed is ripe for disruption. In this new world, the US Fed would be relevant in continuing to operate as a regulator of commercial banks, but the subjectivity involved in facilitating the supply of US fiat currency within the system would be eliminated. In addition to their role in quantitative easing, the establishment of the Fed Funds rate or the interest rate at which banks borrow from each other would be eliminated and instead would be driven by natural market forces. With the turning over of monetary policy to conventions linked to cryptographic currencies, concerning the US Fed, interest rates would no longer be dictated by a sovereign centralized authority. With high levels of inflation, the US Fed will raise interest rates, putting a chill over the economy. Bitcoin is a deflationary currency because of its predictable release of currency units and the fact that the entire universe of bitcoins in circulation will cap at 21 million. In this era of extreme partisan bickering, it is rare when you see an issue championed by those on both sides of the aisle. Currently, there are measures in the US House of Representatives and the US Senate which if passed, would require a regular audit of the US Fed. Senator Rand Paul claims that polling conducted reveals that 70 to 75 percent of the US public believe that auditing of the US Fed would be a good idea. Into this environment comes the transparency of cryptographic currencies which would facilitate transparent financial accountability. In this system, very public market forces combined with a stable, predictable monetary policy would determine economic direction rather than subjective human interference orchestrated behind closed doors.

The bitcoin blockchain would enhance security in terms of password creation and all of the back-office administration (McCalmont Identity). Distributing keys and purified identity, both blockchain conventions, would be the tools used for authentication/verification of identity. Because the blockchain is a decentralized ledger, undergoing transaction confirmations and re-confirmations 24/7/365, inputting false credentials is virtually impossible; also, there is no single "honey-pot" available to those wishing to manipulate the ledger in any way. This is a new level of security that is far superior to the current "cutting edge" systems in place at the NY Fed and compromised by the North Koreans.

Two of the three central banks and the BIS referenced above seem to be in similar places of waiting to see how the technology will play out. The US Fed, ECB, and BIS seem to be very protective of their power and aware of the threat to that power imposed by cryptographic currencies. The PBoC with their dramatic technological advances and strong desire to track the behavior of Chinese citizens (of which a transparent distributed ledger is perfect), seem to be the most aggressive in adopting cryptocurrencies when compared to the other three institutions. In time, major central banks around the world could very well come to see cryptographic currencies, and specifically bitcoin, as a non-biased arbiter of a global standard in monetary policy.

In April of this year, Tim Draper (influential venture capital investor) predicted that bitcoin will hit $250,000 per unit by the year 2022. Currently, there are 17 million bitcoin units in circulation. The current market cap of bitcoin at that price point would be approximately 4.25 trillion. Keep in mind that would be a global market cap under the control of no central bank or government. According to the March 2018 US Federal Reserve Quarterly Report on Federal Reserve Balance Sheet Developments, total assets under control of the US Fed were $4.4 trillion. I fully realize that even at a price point of $250,000 per unit of bitcoin, and the fact that bitcoin is a genuinely universal currency, the idea of bitcoin supplanting currencies maintained by central banks at a projected price of $250,000 per unit is far fetched. That said, it would not be fantasy to consider bitcoin as a reserve currency or baseline to force the other major currencies to observe and use as a guide when establishing monetary policy. This would provide developing economies with a view into global monetary policy and provide them with a fair shake in their goal of global financial inclusion.

If a central bank the size of the US Fed were to announce that they would recognize bitcoin as a global reserve currency, the increase in the price of bitcoin could easily surpass Tim Draper's prediction of $250,000 by 2022. For that recognition, decentralized security, interest rate policy outside the realm of human influence, cross-border economic alignment, and calls for more central bank accountability through transparency on the part of politicians around the world would be met (Central Bank Transparency).

As I've pointed out in prior posts, bitcoin is already used as a flight to safety in Venezuela, Cyprus, Argentina as well as other countries experiencing extreme inflation or threats to their personal accounts by an overzealous centralized government. Each year bitcoin survives and thrives, and global economic and political strife grows, bitcoin could be viewed as a stabilizing global currency. This will transition monetary policy over to stable unadulterated computer code providing economic stability. A human bias-free monetary option. In the book How Global Currencies Work, the authors make the argument that there is only room for one dominant currency as an "international unit of account, means of payment, and store of value." They point to the former dominance of the Pound Sterling, the current hegemony of the US Dollar and wonder if moving forward it will be the Chinese renminbi. I would argue that bitcoin should be taken into consideration.

Liquidity is a necessary element of a viable global currency which is currently not the case due to speculation built into the attraction of holding bitcoin rather than using it in day-to-day transactions. With bitcoin's current price and holding on the part of investors, there are only so many bitcoin to go around which is challenging for it to become a more liquid asset. But as the price per unit continues to rise, the fact that bitcoin can be divided into deci-bitcoins, centi-bitcoins, milli-bitcoins, and micro-bitcoins, will allow for those units that are in circulation to grow in day-to-day transactional activity. The steep rise in per-unit value will continue to grow the circulation as the bitcoin monetary infrastructure matures (as in the case of increased transaction speed), to naturally and legitimately increase liquidity at a much faster rate than a currency under the centralized control of a (non-objective) central bank. It was the order and geographic influence of the British Empire that established the British Pound as the global currency of choice up and until the Bretton Woods Conference (1944) which established the US Dollar as the world's dominant currency. Of the reserve currencies designated so by the IMF, they can be used for international payment by governments and institutions so to put that level of importance in the hands of humans, especially on the part of a central bank when code can run it could be considered irresponsible. The dominance of the US Dollar as a reserve currency puts those outside of the US at a disadvantage. Because the reserve currency is the "common denominator" of all aspects related the global economy, those that live in the US don't have to pay the rates of exchange to hold and transact in the "chosen" currency. Bitcoin adoption as the worlds reserve currency would take this unfair advantage off the table. Also, I would argue that it might not make sense to have bitcoin as the sole digital currency but one of several that operate on the same principle as the International Monetary Fund's Special drawing rights (SDR) basket of preferred fiat currencies (US Dollar, Euro, Chinese Yuan, Japanese Yen, Pound Sterling). The longer bitcoin survives and thrives, the better chance it has becoming the go-to global currency standard. Happy 10th birthday bitcoin!